High Profit Expectations Signal Bad Times For Emerging Markets

By Ben Levisohn

Last year, the iShares MSCI Emerging Markets Index (EEM) exchange-traded fund, gained 19.1%–and investors are hoping for more of the same, if fund flows are anything to go on. They might want to get ready for disappointment.

P/E expansion has been almost exclusively responsible for driving these returns after two years of stagnant earnings growth across the Emerging Markets. This cannot continue indefinitely and we believe earnings will have to play a bigger role in 2013. Consensus earnings expectations look too high, assuming a rebound to 13-14% growth this year. In our own UBS GEM Inc, expectations for our non-financials universe are even higher at 20.9% growth.

The only problem is that earnings growth in UBS’s universe never gets as high as 20%, Smithie says. He writes:

GEM Inc has never enjoyed 20% net income growth, not even in the mid 2000s. That was when global GDP was growing well over 4% a year. In 2013e our economists anticipate a 3% rate of Global GDP growth, more consistent with a mid single digit (6-8%) earnings growth rate. We believe the current high expectations for 2013 will probably be revised down.

Worse still, Smithie says, investors aren’t expecting revenues to pick up, but for profit margins to increase. Yet profit margins have been declining since 2005 because of slower global economic growth. Without a pickup in global GDP, Smithie says it would “be very difficult for margins…to expand sufficiently to drive double-digit earnings growth.”

What should investors do? Smithie recommends “investors rotate from well loved, over-owned parts of the market that have become a harbor of high expectations” and into cheap large markets like China, Russia and South Korea that trade at a discount to the emerging markets index, as well as Indonesia, Thailand, Peru and India. He is also recommends larger-than benchmark positions in financials, energy, consumer discretionary and utilities.

For investors willing to take a gamble on ETFs with miniscule AUMs, EGShares and iShares offer products that give exposure to financials, energy and utilities, including the EGShares Energy GEMS ETF (OGEM).

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. Barrons.com’s Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools. She studies multiple languages and photography.